Life Insurance Explained

Life insurance is necessary in order to lessen the financial impact of certain events that we all hope will never happen to us, but sometimes do. Those events are:

• Premature death
• Critical illness
• Absence from work due to long-term illness or injury

Each of these events affects families in different ways, depending upon their individual financial circumstances, because each will result in a loss of income.

Most commonly people will insure against premature death, which is the cheapest type of cover because thankfully, premature death is the least likely event to occur.

However the impact of critical illness or long-term illness can be just as devastating financially and a normally healthy non-smoking male is four times as likely to contract a critical illness than to die prematurely.

The most basic type of life insurance is called term insurance. With term insurance you choose the amount you want to be insured for and the period for which you want cover. If you die within the term, the policy pays out to your beneficiaries. If you don’t die during the term, the policy doesn’t pay out and the premiums you’ve paid are not returned to you.

There are two main types of term assurance to consider – level-term and decreasing-term insurance. Sometimes a combination of the two is the best answer.

Level-term life insurance policies

A level-term policy pays out a lump sum if you die within the specified term. The amount you’re covered for remains level throughout the term – hence the name. The monthly or annual premiums you pay usually stay the same, too. Level-term policies can be a good option for family protection, where you want to leave a lump sum that your family can invest to live on after you’ve gone. It can also be a good option if you need a specified amount of cover for a certain length of time, e.g. to cover an interest-only mortgage that’s not covered by an endowment policy.

Decreasing-term life insurance policies

With a decreasing-term policy, the amount you’re covered for decreases over the term of the policy. These policies are often used to cover a debt that reduces over time, such as a repayment mortgages. Premiums are usually significantly cheaper than for level-term cover as the amount insured reduces as time goes on.

Family income benefit policies

Family income benefit life insurance is a type of decreasing term policy. Instead of a lump sum, though, it pays out a regular income to your beneficiaries until the policy’s expiry date if you die. The upside of family income benefit is that it’s easier to work out how much you need. For example, if you take home £2,000 a month, you can arrange for the same amount to be paid out to your family if you die.

Unlike life insurance, which is taken out to benefit the insured’s dependants, critical illness and income protection insurances are taken out to benefit the person insured who must be alive to claim. This means that critical illness cover is a suitable recommendation for individuals with no dependants but with a mortgage or other debts.

Critical illness causes families emotional stress in addition to the physical or mental distress and pain. Reducing the financial burden gives them one less thing to worry about at a vulnerable time.

Critical illness causes financial hardship. Even if income is protected by an employer’s scheme or income protection insurance, there is likely to be less disposable income available plus additional expenses, for example, the costs of travel to hospital, childcare, home modifications or treatment not available on the NHS.

Critical illness affects your lifestyle. The in-flow of money maintains a person’s or couple’s lifestyle or businesses profits. A critical illness will disrupt cashflow and limit lifestyle choices.

Formerly known as permanent health insurance (PHI), long-term income protection (IP) is an insurance policy that pays out if you’re unable to work due to injury or illness. IP usually pays out until retirement, death or your return to work, although short-term IP policies are now available at a lower cost. IP doesn’t usually pay out if you’re made redundant, but will often provide ‘back to work’ help if you’re off sick.

Which? says, “Millions of us have policies like private medical insurance and payment protection insurance, sold to us over the years by salespeople who convinced us we needed protecting. However, whilst they were right about the protection, they were often wrong about the policies. The one protection policy every working adult in the UK should consider is the very one most of us don’t have – income protection.”

While a critical illness benefit can alleviate financial hardship by reducing expenses by, for example, paying off an expensive mortgage or loan, it is important not to view it as a replacement or alternative to income protection insurance.

First, critical illness pays out only if the insured is diagnosed with one of the pre-defined critical conditions in the policy, whereas income protection pays out if the insured cannot work whatever the cause might be. As most long-term sickness or disability is due to back problems and mental health issues, which are not covered by critical illness policies, a person with just critical illness cover would not be well served by such a policy.

Second, in order for a policy-holder to use the lump sum payout from a critical illness policy to generate income, they would need to achieve a sufficiently high rate of return and have a sufficiently large sum-assured to invest. According to figures from the re-insurance industry, the average critical illness sum assured is approximately £200,000, but as many as 65% of policies have sums assured lower
than £100,000.

These amounts are simply not sufficient to replace income. Assuming a generous return of 5% per annum, a sum-assured of £100,000 would generate just £416 per month, which represents only a quarter of average net monthly income of £1,800.

Income protection and critical illness are complementary insurances and have specific uses. The former replaces income for temporary or permanent absences from work, dealing with debt payments and household bills, while the latter helps maintain lifestyle in the face of the effects of serious ill health.